"Brexit Risk Premium" to Weigh on Pound Sterling Near-Term, but Better Days Await

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Forex strategists recommend selling Pound Sterling on rising Brexit tensions but this could be a risky strategy longer-term say others eyeing a strong recovery into year-end.

The Pound is vulnerable to a return of a “Brexit risk premium” over coming weeks as talks between the UK and EU show signs of discord, which could result in a failure to strike a deal on a transitional Brexit arrangement at the European Council summit of March 22.

Sterling has fallen in recent days on these fears, and strategists at some notable investment banks are warning that the Pound is likely to suffer yet further weakness as a result of the ratcheting up of tensions.

“Brexit uncertainties have resurfaced after Barnier's warning about the transition period,” says Kit Juckes, chief FX strategist at Société Générale. “The upcoming EU-UK trade talks are likely to be very difficult, and we maintain the long EUR/GBP trade recommendation.”

Juckes and the Société Générale team are therefore betting on a fall in the Pound-to-Euro exchange rate over the coming weeks, which has been their preferred way of exploiting an anticipated increase in market tensions over the progress of transition talks.

Their profit and loss account has received a boost in recent days after Brussels negotiator Michel Barnier told the media that a deal on transitional arrangements is “not a given” if Prime Minister Theresa May objects to Brussels’ demands.

Brussels wants the UK to obey all current and future EU laws when in transition and is also seeking the power to suspend the UK’s access to its markets during if it suspects a breach has occurred. London has objected to the latter and grumbled about the former.

For Sterling, the agreement of a transitional period is crucial as it will ensure a smooth and orderly transition for the economy and financial markets into the final Brexit state. A disruptive process is the absolute worst-case scenario.

The markets are therefore seen to be reacting to the headlines pertaining to Brexit as it did in 2017 when the EU and UK would periodically engage the press as to progress. A pattern soon emerged - the UK would try to play up progress, the EU would warn of a lack of progress and Sterling would inevitably fall.

The pattern was almost quite predictable and the question is whether the pattern remains valid in 2018.

Strategists at global investment bank Morgan Stanley - who have for a long time been bearish on Sterling - believe the return of Brexit woes are one reason to maintain a view that any strength in the Pound is ultimately unwarranted and will yield to notably lower levels.

“Despite the BOE suggesting an earlier and more pronounced rate hike we warn against getting GBP bullish. The BOE has turned more rate bullish as it admitted that the growth potential of the economy has declined to 1.5%,” says Hans Redeker, head of G10 FX strategy at Morgan Stanley, in a note Monday.

“We think that the next GBP upleg to levels to 1.4345/1.4550 offers a long-term GBP selling opportunity,” adds the analyst.

Morgan Stanley are forecasting the Pound-to-Dollar exchange rate to trade down at 1.30 by mid-2018 and end the year at 1.24.

The Pound-to-Euro exchange rate is meanwhile forecast to trade at 1.05 by mid-2018 and 1.06 by year-end.

Elsewhere, analysts at high-street lender Lloyds Bank have updated corporate clients with their forecasts for Sterling againt the Dollar and Euro and they confirm they are expecting downside saying "complex Brexit negotiations may yet weigh on sterling this year."

Lloyds Bank's targets for GBP/USD remain at 1.33 at end-2018 and 1.38 at end-2019, while GBP/EUR is forecast at 1.09 for both end-2018 and end-2019.

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Losses Could be Shallower this Time Around

This time could be different though.

The pattern of Sterling falling after each utterance from EU chief negotiator Michel Barnier might not be repeated in 2018 with some analysts expecting markets to wise up to a EU strategy that sees the EU push the UK with threats of imminent failure but ultimately agreeing to a deal at the last minute.

This is one reason why some are suggesting that any losses arising from renewed fears over the trajectory of Brexit negotiations should be shallower than last time around, particularly given the economic and interest rate backdrop in the UK appears to be more supportive to Sterling in 2018.

"We look for GBPUSD to remain flat a bit below $1.40 over the coming 3M. We still expect incremental progress in the Brexit negotiations, but recent developments indicate that progress towards a transitional arrangement may be slower than previously thought," says Stephen Gallo at BMO Capital Markets.

“While we think the pound's 0.8% decline on the back of Barnier's comment was a bit of an overreaction, we suspect the next couple of weeks may see the return of a short-term Brexit risk premium priced into GBP,” says Viraj Patel, an FX strategist at ING Group.

Patel flags a series of forthcoming speeches by UK government officials, which are expected to reveal the Prime Minister’s new plan for Brexit as well as the government’s attitude to Brussels’ demands for a transition period, as key risks for the Pound this month and next.

“Should noise levels around Brexit increase over the coming weeks, we would expect GBP/USD at best to trade with a 0.5%-1.0% risk premium. We would expect a similar – albeit slightly bigger – risk premium to be priced into EUR/GBP,” the strategist warns, in a note Monday.

Until Barnier’s comments were made, Sterling was riding high with markets more or less in agreement that a transition deal would be struck with plenty of time left to go before the European Council meeting of March 22, where national leaders from across the EU will vote on whether to approve the transitional deal.

Monday saw the Pound-to-Euro and Pound-to-Dollar rates quoted close to four week lows around 1.1256 and 1.3814 respectively.

Above: Pound trades near four week lows agianst the Euro.

“In terms of levels – and assuming the conservative assumption of no change in our fair value estimates – heightened Brexit noise could see GBP/USD trade in the 1.3720-1.3950, with EUR/GBP bouncing around the 0.88-0.90 region,” says Patel, referring to a level of EUR/GBP that translates into a 1.1100 - 1.1360 range for the Pound-to-Euro rate.

Patel and the ING team say an agreement on transition could deliver a boost to both the UK economy and the Pound Sterling, by providing increased certainty about the business environment over the next two to three years, which would support a return of the Pound toward the bank’s bullish targets.

A transition period ensures the status quo remains in place for a so-far unconfirmed period of time after March 2019. The government says it is necessary to ensure companies have enough time to prepare for any changes that will take place after the UK leaves the EU.

“We would look for GBP/USD to move sharply above 1.40 (our 1-month target is 1.43), while in a similar vein, EUR/GBP could fall back towards the lower-end of the broad 0.85-0.90 trading range,” says Patel, referring to the likely implications of a transitional agreement being struck.

For GBP/EUR watchers, this means a move higher in Sterling towards the upper end of a GBP/EUR range of 1.11 to 1.1760 if a deal on transition is reached amicably.

So if Patel and ING are correct, it could be a case of more near-term pain, but longer-term gains.

Also taking a more optimistic stance on Sterling are strategists at TD Securities - the global investment bank - who reckon GBP/EUR could in fact hit 1.20 in 2018.

“With the Bank of England adopting a more hawkish posture at this MPC, we expect markets to converge to our expectation of a rate hike in May,” says Ned Rumpeltin, European head of FX strategy at TD Securities.

“We are adding a short EUR/GBP position to our FX model portfolio. We open this position on a spot reference of 0.8750. Our initial target is a move down to 0.8350 with a stop at 0.9025,” says Rumpeltin.

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